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CHAPTER 22 Powered By Docstoc
					CHAPTER 22

1. (a) The debt increases by 5 million Rags in total; the privately held dept increases by only 4.5
       million Rags because the Central Bank bought 500,000 Rags worth.
   (b) The treasury sale has no effect on the money supply; the Treasury goes to the public to
       borrow money that it immediately spends.
   (c) When Central Bank buys in the open market it pays with new high-powered money that
       becomes a part of the banking system’s reserves; it pays essentially with newly printed
       money. The money multiplier is 1/RR or 1/0.2 or 5. Thus, the money supply expands by
       5 X 500,000 or 2.5 million Rags.

2. Paying down the debt by buying bonds with tax receipts has no impact on the supply of
   money. Money that comes to the Treasury in tax payments is immediately returned to the
   economy as the bonds are paid for by the Treasury. The result is that there is no change in
   reserves. When the Fed buys bonds in open market operations, it uses what is essentially
   printed money. The whole point is to expand reserves and thus the money supply.

3. Cash: Asset—Bank has it on hand.
   Demand Deposits: Liability—claims by depositors can be withdrawn at any time.
   Savings deposits: Liability—same logic.
   Reserves: Assets—They are in the vault as cash or on deposit with the Fed.
   Loans: Assets—They represent claims of the bank on borrowers.
   Deposits at the Fed: Assets—They can be withdrawn at any time; they are owned by the bank.

4. Decrease the reserve ratio: that would immediately free up reserves (create excess reserves)
   system wide. Banks could lend more expanding the money supply.
       Decrease the discount rate: encouraging banks to borrow reserves and lend more money,
   expanding the money supply.
       Buy government bonds. The Bank of Japan pays with cash or by increasing deposits in
   banks’ accounts. This increases reserves in the system and expands the money supply.

5. Reducing the reserve requirement means that reserves of 6.24 million hurls can support 62.4
   million in total deposits. The money supply could increase by as much as 10.4 million hurls.
   The Central Bank could counter with open market sales of bonds, withdrawing reserves from
   the economy.

6. If banks are loaned up and the money supply is $1,148 billion, the 10 percent reserve
   requirement would imply $114.8 billion in reserves. If the reserve requirement were raised to
   11 percent, $114.8 billion is 11 percent of $1,044 billion. Raising the reserve requirement to 11
   percent would reduce the money supply by $104 billion.

7. If the army is unaware of the king’s scheme, the plan will work temporarily, but it will also
   lead to an increase in the money supply, with all of the macroeconomic effects that will be
   studied in the next few chapters. (It will be shown that this plan will cause inflation.) If the
   army is aware of the king’s scheme, there will be immediate inflation. The army would
   demand that the king pay them ten percent more coins for their wages.

8. M2 includes everything in M1, plus savings accounts, money market accounts, and some
   other categories. A shift of funds between, say, savings accounts and checking accounts will
   affect M1 but not M2, because both savings accounts and checking accounts are part of M2.

9. (a) Agree. The two sentences are correct. When the Fed sells bonds, the proceeds do not go
       back into circulation. Rather, the proceeds are withdrawn from the economy, reducing
       the quantity of reserves in the system and reducing the supply of money. Fed open
       market operations change the money supply.
    (b) Disagree. The expenditure (fiscal) multiplier is equal to 1/MPS. The expenditure
        multiplier and the money multiplier are very different. The expenditure multiplier gives
        the change in equilibrium output (income) that would result from a sustained change in
        some component of aggregate expenditure. The money multiplier gives the change in the
        stock of money in circulation resulting from a change in reserves. The money multiplier is
        equal to 1/(required reserve ratio). It has nothing to do with the MPS.

10. Money injected through open market operations results in a multiple expansion of the money
    supply only if it leads to loans, and loans can be made only if the new money ends up in banks
    as reserves. If the Fed buys a bond from James Q. Public, who immediately deposits the
    proceeds into a dollar-denominated Swiss bank account, the U.S. money supply won’t expand
    at all. If the money ends up in his pockets or in his mattress, the expansion of the money
    supply will stop right there. If he had deposited the proceeds in a U.S. bank, excess reserves
    would have been created, stimulating lending and further money creation.

                                       b       g
11. (a) The bank is required to hold .1 $3,500  $350 in reserves.
    (b) Excess reserves  $500  $350  $150 .
    (c) Assuming that money lent out by the bank gets deposited in this same bank, the bank can
        lend out an additional $150 1 .1  $1,500 .
    (d) New T-account:
                   Assets                 Liabilities
        Reserves      $300         Deposits    $3,300
        Loans         $3,000
        Required reserves are now $330. The bank has deficit reserves of $30. The bank will need
        to reduce its loans and increase its reserve by at least $30. This would result in reserves of
        $300, loans of $2,700, and deposits of $3,000.


1. (a) Disagree. A rise in Y increases the demand for money as more transactions take place, but
       the supply of money is unaffected.
   (b) Disagree. Ceteris paribus, a rise in P means that each transaction is more expensive and
       households and firms need to hold more money, not less.
   (c) Disagree, again. When the Fed buys bonds, it expands the money supply. The supply
       curve shifts to the right. When we experience a recession (Y falls) the demand for money
       falls, shifting the demand curve to the left. Both tend to push interest rates lower.

2. A decline in P would shift the money curve to the left since transactions would require less
   money. If the Fed held the money stock constant, interest rates would fall.

3. If households believe that interest rates will rise, why should they lend money now? They will
   desire to hold more of their wealth as money for the time being, betting that they can get a
   higher interest rate if they wait. If they buy bonds now, they risk a capital loss (a decrease in
   the value of their assets), because bond prices fall when interest rates rise. When households
   hold money to speculate in this way, we call their motive for holding money the ―speculation

4. This is what Keynes called a ―liquidity trap.‖ Expanding money supply would not push
   interest rates lower. The public would essentially hold as much money as we inject into the
   system. Since, as you will see, monetary policy works through lowering or raising interest
   rates, it will not work to stimulate the economy if the money demand curve is flat.
5. (a)    r              Ms                             (b)   r              M0 M 1
                                                                              s   s

          r2                                                  r2
          r1                                                  r1
                                     Md                                               M0
           0                                   M               0
                         M                                                                          M

6. (a)     r        Ms        M s'                      (b)


          r1                             Md
                                      M d'
           0   Ms        Md           r

    (c)    r        Ms        M s'                      (d)    r        Ms        M s'

                                           M d'               r1                           Md
           0   Ms        Md           r                        0   Ms        Md            r


7. A recession is a decline in real GDP. When                  r             Ms
   output falls, there is less economic activity and
   fewer transactions. Fewer transactions means
   that (ceteris paribus) money demand will fall.
   This will cause a leftward shift in the M d curve,                                          0
   which results in a lower equilibrium interest rate         r2
   (assuming that the money supply remains fixed).

8. Ceteris paribus, an expansionary fiscal policy at a time when the Fed want to hold the rate of
   growth of the money supply steady will drive up interest rates. First, the added expenditure
   will push up the growth of real GDP. The increased spending and GDP would increase the
    demand for money, M d . If the Fed holds the line, M d  M s and rates will rise. At the same
    time these policies hit taxpayers, the Asia crisis of 1998 hit the U.S. economy and slowed
    down the growth of real GDP as exports to Asia fell. By early 1998, the Fed was even thinking
    of expanding M s to push r down to restore GDP growth.
      r            Ms                                         r           M1 M2
                                                                           s  s

      r                         1                                                       1
                              Md                             r2                      Md
                         Md                                                       Md

          0                         M                         0                             M
              Expansionary fiscal                                   Slowdown from Asia
               policy; Fed holds                                     crisis; Fed expands

9. (a, b)                                                    The equilibrium is at r .5 or 50 percent, which
                                                             is found as the intersection of the money
             .75                   B                         demand and money supply curves. Alternatively,
                                                             we can solve for r algebraically by setting
                                      M2                     Md  M s :       10,000  10,000r  5,000  10,000
             .50                   A                          r  5,000 10,000  .5 .
                                                         (c) With Y  7,500 , the intersection occurs at
             .30                                             r .75 .
                                                             Algebraically,10,000  10,000r  7,500  10,000
                                                              r  7,500 10,000 .75 or 75 percent. The
             .10                     M1                  (d) money demand curve shifts right.
                0                                            We need a money supply equal to what money
                       5,000 10,000 15,000
                                                             demand would be when r .5 . M d  10,000
                               Money        17,500
                                                             10,000.5  7,500  12,500 . Increase the money
                                                             supply by $2,500, to $12,500.
    (e) One possibility is that the price level has fallen, shifting the money demand curve back to
        its original position.


1. Rates in 1980 were much higher due to higher inflation and higher expected inflation. The
   higher interest rates in 1980 were due to a higher ―inflation premium‖ based on this expected
        In 1980, most debt holders believed that the inflation rate would decrease in the future.
   Long-term debt thus had a lower inflation premium than short-term debt. In 1993, the
   situation was reversed: inflation was unusually low, but many debt holders were wary of
   higher inflation rates in the future. Thus, it was long-term debt in this case that carried the
   higher inflation premium.


1. (a) Peabody should hold the amount of money that maximizes the ―net profit‖ from holding
       money, balancing the convenience of money against the opportunity cost of foregone
    (b) At r  10% per month:

               Number       Average      Average     Interes     Cost of     Net
                     of     Holding       Bond             t     Switch     Profit
               Switches                              Earned
                  0           $750          0           0           0          0
                   1           375         37.5        37.5         4         33.5
                  2            250        500          50           8          42
                  3            187.5      562.5       56.25         12       44.25
                  4            150        600         60            16         44

        The optimal number of switches is 3, with average money holdings of $187.50.
    (c) At r  15% per month:
               Number       Average      Average     Interes     Cost of     Net
                    of      Holding       Bond            t      Switch     Profit
               Switches                              Earned
                                $750        0          0            0         0
                   1             375       37.5       56.2          4        52.25
                   2             250      500         75            8        67
                   3             187.5    562.5       84.37        12        72.37
                   4             150      600         90           16        74
                   5              12.5    625         93.75        20        73.75
        The optimal number of switches is 4, with average money holdings of $150.
        An increase in the interest rate to 20% would lead to a further increase in the optimal
        number of switches, and a further decrease in average money holdings.
    (d) The demand for money curve slopes downward because at higher interest rates, holding
        money entails a higher opportunity cost (foregone interest). Individuals will try to
        economize on money holdings at higher interest rates.


1. The bank hoped that the rate cut, brought about by an increase in the money supply, would
   increase investment spending (I). This would cause C+I+G>Y, inventories would fall and
   GDP (Y) would rise. Y increasing would set off a multiplier with C rising.

2. A cut in T increases disposable income Y d . C rises as a result as does S. C  I  G is thus
   bigger than Y, inventories fall and Y rises. There would be a multiplier. By assuming no
   change in interest rates, there would be no direct effect on C, I or G from the debt reduction.
   (Note: There could be a portfolio effect. The supply of bonds decreases, households try to shift
   from money to bonds, and bond prices rise driving r lower. However, we assumed the Fed
   holds rates constant which it could do by reducing the supply of money.) Because the tax cut
   is more expansionary, Y will rise, driving up the demand for money. To get the economy to
   slow r will have to rise more than it would have under the debt reduction story.

3. Taxes (T) rise, causing disposable income Y d to fall. When Y d falls, C falls, causing AE  Y .
   When AE  Y , inventories rise and firms cut back on output/income: Y falls and
   unemployment rises. If I were the central bank and I wanted to counteract these effects, I
   might lower interest rates to try to stimulate investment with expansionary money policy.

4. (a) If investment depended in no way on interest rates, planned investment in Figure 12.2
       would be represented as a vertical line.
   (b) A change in interest rates would cause no change in planned aggregate expenditure
       because planned investment would not change. (One could argue that consumption
        spending might change, but we have not yet discussed the impact of interest rates on
        consumption spending.)
    (c) Fiscal policy would become more effective than monetary policy. Fiscal policy directly
        influences aggregate output by changing government spending or consumption, and
        would still be effective. (Indeed, it would be more effective, since in this case there would
        be no crowding out.) Monetary policy depends on the responsiveness of investment to
        changes in interest rates to influence aggregate output, and would become completely

5. (a) Because these two policies have opposite effects on aggregate spending, the result is
       ambiguous. The tax cut raises Y d and thus C. C  I  G  Y . Inventories fall and Y rises. At
       the same time, if M s is cut by the Fed, r rises. Higher r leads planned investment (I) to
       fall. Lower I implies C  I  G  Y inventories rise and Y falls. The only thing certain is
       that r will rise because the tax cut leads to an increase in M d .
   (b) In 1998, the tax cuts cause disposable income to rise. When Y d rises, C increases and
       C  I  G  Y . Inventories contract, causing Y to rise. Higher Y causes money demand M d
       to rise. If M s is fixed, that will cause r to rise. In 1999–2000 the story is reversed. The
       expenditure cuts kick in, causing G to fall. C  I  G  Y , inventories rise, Y falls. That
       causes money demand to fall and with M s constant, r will fall.
   (c) The tax increase reduced disposable income and thus consumption. C  I  G  Y , so
       inventories build and output falls. A lower Y means lower money demand. At the same
       time that the Fed is increasing the money supply, interest rates will fall sharply, causing I
       to rise, perhaps offsetting the effects of the initial tax increase on Y. (Final result:
       ambiguous Y, lower r.)
   (d) The drop in consumption cuts aggregate expenditure: C  I  G  Y , so inventories rise
       and Y falls. As Y falls, money demand drops. If the Fed holds M s constant, r will fall.
       Here again, the lower r may stimulate I, causing I to rise, partially offsetting the initial
       decline in Y. (Final result: lower Y, lower r.)
   (e) The Fed expands the money supply. M s  M d , so r falls. Normally, the lower r might be
       expected to cause I to rise, but gloomy expectations and no need for new plant and
       equipment keep I low. Thus the link to the goods market is broken, and the monetary
       policy doesn’t have much impact. (Final result: lower r, little or no change in Y.)

6. (a) Increased investment spending would cause an increase in output (income), which would
       increase money demand and drive up the interest rate. The Fed could be expected to
       respond with an increase in the money supply to hold down the interest rate. Output,
       consumption, saving, and investment spending would increase. The interest rate would
       remain constant.
   (b) The money supply would decrease, causing an increase in the interest rate. The Fed
       would respond with an increase in the money supply, bringing the interest rate back
       down to its original level. In the end, there would be no change in output, consumption,
       saving, investment, or money demand.

7. (a) The decline in investment would be a reduction in aggregate expenditure, causing
       equilibrium output (income) to decrease in the goods market. In the money market, the
       drop in income would decrease the demand for money (shift the M d curve to the left),
       causing the interest rate to fall and investment spending to rise back up somewhat. But
       the net effect would be a decline in output (income) and the interest rate.
   (b) Option 3 is the most expansionary, because the increase in the money supply works to
       offset the crowding-out effect. Option 2 would come next, but would involve some
       crowding out. Option 1 would be at least expansionary, because the tax increase would
       decrease consumption spending. (Option 1 relies on the balanced-budget multiplier,
       which has a value of 1. Option 2 relies on the government spending multiplier, which is
       larger than 1.)
8. Investment may not respond positively to low interest rates during a recession because
   decreased production may have left the firm’s existing capital underutilized. In this case,
   there would be no incentive to buy new plant and equipment. Investment may not respond
   negatively to high interest rates during a boom because the increased consumer demand
   arising from increased income may make expansion profitable despite the higher cost of


1. (a)     r                     LM                  (b)    r                    LM 1
                                                                                        LM 2

          r1                                               r1
                                              IS 2

                                             IS 1                                IS 1 IS 2
                      Y1 Y2                                           Y1   Y2
                      Output                                            Output
   (c)     r                   LM 1                  (d)                         LM2
                                        LM 2                                           LM1
                                      IS 1                                              IS 2
                               IS 2                                           IS 1
                                                                      Y1 Y2
   (For part (c) and (d), output can either increase or decrease, depending on the relative shifts
   of the two curves.)

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